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Three Fathers of Investing

BENJAMIN GRAHAM

The world of investing changed dramatically in the post Depression 1930s. At this time Benjamin Graham was evaluating the systems and trying to understand how ordinary people could rebuild their decimated finances. The result was a book he published in 1949 entitled ‘The Intelligent Investor’ which Warren Buffet read in 1950 at the age of 19. Years later in 2003 Buffet declared that this was still his favourite book.

Graham is most famously remembered as the father of value investing and Warren Buffett’s teacher at Columbia Business School. In his book, Graham listed the things he thought the public should look for when looking to employ a professional investment manager:

Their fees are cheap. Funds with higher fees earn lower returns.

Managers should be the biggest shareholders

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They must dare to be different

They don’t do a huge amount of advertising or marketing.

Warren Buffett and Benjamin Graham both think low cost index funds are the best choice for individual investors, and that past performance is virtually the least important factor because:

also, today’s losers rarely do better so avoid funds with poor performance record

Graham’s core principles are that the future value of every investment is a function of its present price. The higher the price you pay, the lower your return. No matter how careful you are, you need a ‘margin of safety’ which means you should never overpay once you have considered all risks. In his book Graham says, “It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity–provided that the buyer is informed and experienced and that he practices adequate diversification. For if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.”

He believes that the secret of financial success is inside the person if

they can be a critical thinker

they can invest with patience and confidence

And that the underlying principles of sound investment should not alter from decade to decade, but the application of these principles should be adapted when significant changes in the financial markets and climate happen.

Graham sees two types of investors. One category are Defensive investors whose chief aim is avoiding losses, and have a desire to put in low effort and make infrequent decisions. The other category are Enterprising investors whose determining trait is a willingness to devote time and care to the selection of what they invest in. These investors are seeking a slightly better return and believe expecting significantly higher returns is unrealistic.

At SCM Direct we thrive to be intelligent investors.

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HARRY MARKOWITZ

As a student at the University of Chicago, Markowitz was especially interested in the philosophers he read in a course called ‘Observation, Interpretation, and Integration’. This led him to question economic and market theories in his dissertation that formed the basis of his Portfolio Theory.

In 1952, Markowitz published his breakthrough work on the modern portfolio theory that later won him a Nobel Prize. His theory stated that it was possible for investors to construct efficient portfolios that would offer maximum possible returns for a given level of risk.

Markowitz explained that a major tool in achieving this was to create diversified portfolios that reduce risk and maximise returns. In other words, don’t put all your eggs in one basket’.

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His hypothesis was how do you manage uncertain situations? His answer was to consider the actions you could take, and diversify. It might not be the one answer to all your problems, investments or otherwise, but not doing it is more risky. Or as he put it, ‘I diversify, therefore I reduce risk’.

A quote that is dear to Markowitz’s heart is ‘I think, therefore I am’ ( Cogito ergo sum).

‘The best business managers, are the ones who cope best with their lack of knowledge. As a manager, you need to go through different layers when you have to deal with uncertainties. Very importantly you have to understand that you don’t have information, you have data.” “Investment managers should always be aware of their lack of knowledge.”

According to Markowitz, there are four basic steps involved in portfolio construction:

Security valuation

Asset allocation

Portfolio optimisation

Performance measurement

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WILLIAM SHARPE

William Sharpe built on Markowitz’s work. Sharpe’s prize-winning work changed the way professional investors think about stocks. While much of it is technical, his capital asset pricing model (CAPM), focused on the relationship between risk and reward in the context of the entire market. As Sharpe says: “Some investments have higher expected returns than others. And they are the ones that will do the worst in bad times.” In other words, if you want higher returns, you’ve got to take some of the market’s overall risk.

In theory an investor would be assured of a return that equalled that of the market as a whole if he or she owned a portfolio that encompassed all traded stocks. But Sharpe found that in fact, low-cost index funds allow investors to come close to that ideal state, and are an excellent alternative to traditionally managed portfolios for many investors.

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It’s important to remember that investments have costs such as management and stock broker fees that reduce profits. And here’s where Sharpe takes ‘sharp’ issue with the conventional “stock-picking” approach to investing.

“A lot of people have a strong vested financial interest in saying ‘I know how to beat an index fund,’ and if you torture a body of data long enough it will confess to anything you want. I’d be skeptical of anyone who assumes there is a simple formula to get something for nothing.”

Sharpe says that by using the tools of his financial economic theory and empirical research, investors can find efficient strategies that provide diversification at low cost.

Sharpe’s major CAPM theory offers investors a way to quantify risk; it’s called beta, a concept that has become a standard financial tool. Beta measures a stock’s relative volatility–that is, it shows how much the price of a particular stock is likely to jump up and down when the stock market as a whole moves. On average a stock with a beta of 1 would move in line with the market, while a stock with a beta of 1.5 would likely rise by 15 percent if the market rose by 10 percent, and fall by 15 percent if the market fell by 10 percent.

Sharpe maintains that his investment philosophy can be summed up by his four-verb mantra:

Diversify. This is pretty simple. As with property where the mantra is location, location, location; with investing it is diversify, diversify, diversify. For many investors a few highly diversified low-cost index funds may suffice.”

Economise. If an index fund is right for you, as it is for many investors, why spend a lot of money on management fees in a likely vain attempt to beat the market? In financial jargon, index funds are “passively managed”– which often means your adviser or fund manager doesn’t have to do much and therefore can’t charge very much. Active management, which includes stock-picking, tends to charge a lot more. Of course, investors willing to bear additional risk may want to earmark part of their portfolios to potentially market-topping ideas.

Personalise. This may seem obvious, but there’s more to it than you might think. As an example, Sharpe talks about an investor who works and owns a home in Silicon Valley. Personalising her portfolio might well mean underweighting technology stocks, since a downturn in the Valley could cost her job and knock a big percentage off the value of her home. So why risk having the retirement portfolio going down as much with the other ships. At SCM we have gone a step further and developed three portfolios, which individually or when blended, can satisfy many people’s different levels of risk appetite.

Contextualise. Here Sharpe departs a bit in his focus and is speaking more to the advisers and fund managers when he says:

“Asset prices are not set in a vacuum. … It is impossible to choose an appropriate portfolio without a coherent view of the determinants of asset prices.” In other words, consider the underlying factors, whether it is CAPM or any other theories that are likely to move markets.

William Sharpe developed the Sharpe Ratio to help determine whether an active investment manager is “beating” the market after adjusting for the risk that the manager assumed. He believes that markets are too efficient to beat consistently.

Sharpe has become something of a celebrity in the academic community, and his words get a lot of attention, but since he first published in 1964, he and 10,000 of other researchers have thought more about these issues and have much more empirical data to work with.

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UK Academics

ELROY DIMSON

Emeritus Professor of Finance at London Business School; co-designer of the FTSE 100 index.

Much of modern investing thinking has emanated from the US but there have been some thought leaders in the UK. Our co-founder and Chief Investment Officer (CIO) Alan Miller had the honour of being taught by one, Professor Dimson at the London Business School.

Professors Elroy Dimson and Paul Marsh of the London Business School wrote in their 1998 paper entitled ‘Murphy’s Law and Market Anomalies’ that “Many researchers have uncovered empirical regularities in stock market returns. If these regularities persist, investors can expect to achieve superior performance. Unfortunately, nature can be perverse. Once an expected anomaly is publicised, only too often it disappears or goes into reverse”.

In the Professor’s joint presentation in 2013 entitled ‘Investing in a Low Return World’, they conclude:

We are in a low return world

Investing has become more challenging

Need to search for rewards that go beyond just the equity premium

Need to control risks, and to diversify across assets, markets and premia

ALAN MILLER

Founding Partner and Chief Investment Officer

Our CIO, Alan Miller, wrote a prize winning dissertation in 1985 comparing Active with Passive Portfolio Management in the light of the Efficient Markets Hypothesis which concluded there were very few anomalies left in fund management.

32 years later he finds himself in the fortunate position to co-own an investment business that can turn this abstract thesis into practise.

At SCM Direct, we continue to monitor research from around the world, conduct our own, listen to our clients, look at economic and market trends and combine our day to day investment activity with a thirst for improving our clients’ outcomes.

Focused on What We Can Control

Many researchers have found that asset allocation has a significant impact on overall portfolio returns.

Asset allocation is an investment technique used to spread investment pots across asset categories. Equities, bonds, commodities and cash are the most common component, however there are others e.g. private equity and property.

By using asset allocation to invest in different assets that respond differently to the same market forces, this helps to smooth investment returns as some assets will be performing well when others perform badly, and vice versa. But it is important to remember that all investing involves risk and that there can be no guarantees.

Academic researchers Ibbotson and Kaplan found ‘the average of all investors is the market itself, with good managers and bad ones cancelling each other out, so that asset allocation ultimately accounts for 100% of the absolute level of returns

Government Bonds are represented by the Citi Group World Government Bond UK All Maturities Index

Corporate Bonds are represented by the iBoxx £ Corp Index

Cash is represented by the JPM UK Cash (3 Months) Index

High Yield Bonds are represented by the Bank of America Merrill Lynch Global high Yield Index

Average Weighted Portfolio is composed of equal weightings of all other represented indices.

The average weighted portfolio is for illustration purposes only to show the effect on returns of investing in a combination of asset classes, rather than a single asset class. It is not a recommendation for diversified portfolio construction.

Source: BlackRock, Datasteam. Data as at 31 December 2014. Total Return Indices shown.

Tactical Strategic Asset Allocation

Tactical asset allocation is when an investor believes that they can get better risk-adjusted returns by dynamically changing asset allocations rather than following a rigid, fixed ‘buying, holding and hoping’ method of asset allocation.

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At SCM Direct we describe ourselves as actively passive as we undertake tactical strategic asset allocation i.e. we believe in being active in our asset allocation, but use passive index funds called Exchange Traded Funds (ETFs) to fulfil our asset allocation decisions; offering clients the best of both worlds. By only investing in ETFs which are modern, low cost, and highly diversified, we are able to be extremely nimble and efficiently implement our tactical asset allocation decisions.

We do not buy, hold and hope. The SCM Direct team constantly monitors the portfolios against the overall economic and market environment. We concentrate on various tried and tested, long-standing fundamental valuation criteria to assess if the potential rewards from owning a particular asset exceed its potential risks.

Our disciplined investment approach involves careful research and a determination not to blindly follow the herd. Some of the best decisions can be counterintuitive and an independent mind-set is vital in our view to successful asset allocation. Our Chief Investment Officer, Alan Miller has 28 years investment experience and is one of the UK’s most successful fund managers.

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SCM Direct’s Asset Allocation Strategy Aims To:

Highly Diversified Portfolio

Diversification goes hand in glove with asset allocation. It means spreading your investment pot around different investments to reduce risk. When buying a house the experts advise you to think location, location, location; in investments it’s diversification, diversification, diversification.

Diversification serves as a safety net but cannot guarantee to reduce risk completely. It’s a fundamental tool which helps us address our clients concerns around risk.

Coupled with our tactical asset allocation decisions, it means we never have all our eggs in one basket.

We choose different asset classes that often fluctuate independently of each other as we aim to reduce the volatility of the SCM Direct portfolios.

Baskets of Baskets

Using Exchange Traded Funds (ETFs) To Enhance Diversification

A well-diversified portfolio should be diversified at two levels: between asset categories and within asset categories. Therefore in addition to investing the portfolios amongst equities, bonds, cash, and possibly other asset categories, we also spread our investments within each asset category by investing through well-diversified index funds, ETFs. We believe ETFs are ideal, as they are highly diversified index products that fulfil sophisticated investment strategies in an efficient, fully transparent and low-cost manner.

All the portfolios hold a wide variety of ETFs, investing in a diversified basket of large and liquid indices across different asset classes to protect against the risk of loss from failing companies. This is called diversification, although we typically hold between 10-20 ETFs in each portfolio, the underlying holdings, which are held within these ETFs, place the SCM portfolios amongst the most diversified in the UK.

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The value of investments can go down in value as well as up, so you could get back less than you invest. It is therefore important that you understand the past performance is not a guide to future returns. Exchange rates may cause the value of overseas investments and the income arising from them to rise or fall. SCM Direct does not give personal advice. We aim to provide investors with simple, understandable information so they can make fully informed decisions.
If you are unsure about the suitability of our investment portfolios please contact an independent financial adviser.
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